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Substitutes and Complements

At yesterday’s RFF/AEI/Brookings carbon tax conference, the first two speakers correctly emphasized that with the right price in place, we wouldn’t need the panoply of indirect alternative policies to reduce greenhouse gas emissions, such as renewable portfolio standards and clean energy subsidies. The following speaker, however, referred to these indirect policies as “complementary.” That characterization is almost always wrong—and it matters.

In economics, A and B are complements if having more of A means that one wants more of B, the classic example being hot dogs and mustard. However, if having more of A means that one wants less of B, or vice versa, A and B are called substitutes. A simple example would be that having more Hondas reduces the desire for Toyotas.

As the first two speakers at the conference said, if we get the carbon price right through as tax (or cap and trade program), arguments for the alternative policies weaken. This makes those alternative policies substitutes for a carbon tax, not complements. When the costs of emitting GHGs is incorporated in the prices of producing or using energy, people can then decide whether to adopt or invest in renewable power sources, invest in energy efficiency, or simply use less energy in response—in effect, choosing the method that reduces carbon emissions at the lowest cost.

This is exactly why renewable standards, clean energy subsidies, energy efficiency promotion and the like are not complementary. The higher a carbon tax, the less we need other policies to reduce emissions. As policies for reducing emissions, these alternatives make sense only when we can’t get the carbon price right. Were they really complementary, we’d need them less absent a carbon tax, and we’d want them more with one—the opposite of what’s the case.

There is one exception, for which I credit my RFF colleague, Carolyn Fischer. She’s found that sometimes clean energy research and development can be a complementary policy. Without a carbon tax to provide economic incentives to reduce carbon, successful clean R&D will have no market value, so funding it makes little sense. So, instead of “all” alternative policies are substitutes, it’s “almost all.”

I can only speculate as to why the erroneous designation of “complementary” started and persists. To build support for climate polices, one wants to spread the potential benefits. These alternative policies essentially designate specific methods for mitigating carbon emissions, so they ensure that suppliers of renewables, clean energy, and energy efficiency get their piece of the pie. To help justify doing so, it may help can call them “complementary.”

What difference does a word make? Admittedly, as an economist I have an academic interest in wanting terms used correctly. However, economics is full of terms—”rational”, “efficient”, “competition”, “welfare”—that can be misused (including by economists) to distort the case for and against particular policies.

In this context, it can matter because of how the carbon tax political bargain may play out. Since the alternative policies are substitutes, advocates of carbon taxes should be gladly willing to sacrifice renewable standards, energy efficiency subsidies, and similar programs—not to mention piecemeal EPA regulations—to attract support from those programs’ opponents. As long as advocates of these policies insist that they are complementary, carbon taxes, sensible both as climate policy and as part of the solution to the country’s fiscal situation, will be harder to enact.

 

About Timothy J. Brennan

Tim Brennan focuses on public policies involving monopolies and market power, and on assessing methods for policy evaluation. He looks particularly at issues associated with restructuring the electricity sector and opening electricity utilities and markets to competition. Specific topics in recent publications include real-time pricing, climate change, network effects, decoupling electricity revenues from use, energy conservation policy, and space launch risk.

Views expressed above are those of the author. Resources for the Future does not take institutional positions on legislative or policy questions. All information contained on Common Resources is intended for informational and educational purposes and may only be used for these purposes. Please see RFF's Terms of Use for further information.

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  1. […] week, RFFers participated in day-long workshop hosted by the American Enterprise Institute on the multiple policy dimensions of a carbon tax.  A […]

  2. […] Indeed, in those states that have already adopted CO2 budgets, including the RGGI states and California, energy efficiency does play an important role as a “complementary policy.” In RGGI a large portion of the revenues from the emissions allowance auction is used to fund energy efficiency programs in each of the participating states. It is important to recognize that if an emissions budget is binding (that is, the target is below emissions levels that would have occurred without the budget) then energy efficiency policies are unlikely to reduce emissions below the budget target. Instead the effect will be to reduce the price of CO2 emissions allowances (which my colleague Tim Brennan reminds us makes the energy efficiency policy and the CO2 budget substitutes, not complements, from a strict economics perspective). […]



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